The credit crunch isn't that complicated, but the tendency of the media to focus on day-to-day events means that one can quite easily lose sight of the sequence of events that tied the global economic meltdown together. The meltdown has had three phases so far, which I will now briefly explain.
Stage one: the credit boom
The first stage of the economic crisis was a credit boom. This was the nicest part of the crisis to live through, and it didn't really feel like a crisis at all, because its main characteristic was that everyone had a lot of money. This was a time when economic growth was good, house prices and stocks kept rising, and everything seemed hunky dory. This climate of easy money and growth was created by governments, who deregulated lending practices and adopted monetary and fiscal policies that flooded ever more money into the economy. It was also brought about by an unprecedented injection of money into western credit markets from growing countries of the Far East, particularly China.
Some of the impacts of this appeared positive. For instance, it led to a boom in property prices, which meant that a lot of families and companies became, on paper, a lot richer. It also meant it was easy for businesses to borrow money, which they could use for economic growth and employing people. Finally, governments themselves could borrow money, which they could use to spend on public services, not to mention the wars that they have become rather fond of since the late 1990s. All of this, apart from possibly the wars, seemed to be a short-term benefit.
But much deeper problems were brewing. The easy availability of money and credit had negative consequences as well. There was so much money sloshing around that banks and other financial institutions ran out of safe places to put it, and so they started to make risky investments. While this was by no means limited to the housing market, property prices provide a glimpse, in microcosm, of what was happening elsewhere. Banks had such a suffusion of money that they wanted to lend that they became willing to provide mortgages to people who were in no fit economic state to give them their money back. These were the so-called sub-prime mortgages which we heard so much about several years ago.
The people who took out sub-prime mortgages were people with bad credit histories and a greater probability of defaulting on their loans than normal borrowers. In other words, banks were taking a big risk in lending to them; but such was the free and easy credit flowing around the economy, banks presumed that continued rises in house prices and continuing positive economic conditions would minimize their losses. The development was accompanied by much dogma about how there was a glorious new era of mortgage finance which opened up the possibility for everyone - even those with bad credit histories - to enjoy the dream of home ownership. Any politician standing against this tide could easily be demonized as an enemy of the poor and downtrodden, and even government-backed entities like Fannie Mae got in on the sub-prime party.
While the large banks and mortgage-lenders continued to bet that they could weather the risks of their own bad investments, the aggregate figures across the whole economy were starting to get scary. By March 2007, the total value of sub-prime mortgages in the United States was $1.3tn, and they were accounting for about 20% of all new mortgages. This meant that if a substantial number of sub-prime mortgage-holders defaulted on their loan - as, by definition, they were wont to do - the banking system would suffer an enormous loss of money.
This was made even worse by the final piece of the puzzle, which was something you may have heard referred to as "securitization" or "exotic financial instruments". There was so much money sloshing around that wanted a piece of the mortgage market that there simply weren't enough people to lend mortgages to. As a result, large mortgage-lenders came up with what seemed to them a clever way to make yet more money from their mortgage provision: they would sell other investors a piece of the action. They sold these investors exposure to their mortgages, promising to pay X% interest on an investment, using the money they took in monthly mortgage payments to pay the interest. Investors scrabbled from all over the world to invest in these deals, buying their chunk of the booming U.S. mortgage market. This bought them a share of the profits, while there were profits to be made, but it also bought them a share of the disaster that was about to strike.
Stage two: the credit crunch
By early 2008, about 25% of sub-prime mortgages were failing, meaning that the banks weren't getting their money back on their investments. This was triggered by the end of the U.S. house price boom; property prices had gone to dizzying highs thanks to the availability of credit and easy mortgage finance, but underwent a rapid decline of 20% from 2006 to 2008 as it became apparent that houses were over-valued. As prices declined, people had difficulty refinancing their mortgages, and they began to go into default. By September 2009, 14.4% of American mortgages were either delinquent or in foreclosure. Ironically, one factor which made it harder for people to keep up their mortgage payments was that the U.S. Federal Reserve finally decided to increase interest rates from 2004 to 2006, making finance more expensive for those on tracker mortgages.
As householders began to go into default, mortgage-lenders started to lose money. Even worse, all the people who had invested in these mortgages via exotic financial instruments started to lose money as well. It quickly became apparent that investors all over the world had been over-confident about the safety of their mortgage investments and that, just like every other boom in history, this one would indeed also end in a bust. The diffusion of exposure to the American mortgage market all over the world meant that financial institutions in Europe were affected, as well as their American counterparts.
Even worse, it was very hard to know which institutions would be the most affected, because the institutions did not tell the world how much potentially bad mortgage debt they held. Horrifyingly, it quickly became apparent that the people in charge of many of these banks often didn't know how big their exposure was either, because they didn't understand many of the exotic financial products that their whizkids had dreamed up to make a quick buck during the boom years. This was when the credit crunch got started good and proper; not only were banks losing money from their bad debts, they suddenly became far too paranoid to lend money to anyone else until the storm had passed. Why lend money to another bank or a corporation when it could go bust at any minute because of its own exposure to bad mortgage debt? Best to hunker down, sort out your own problems, and return to the market later.
The sudden unwillingness of everyone to lend to everyone else caused massive problems for an economy which had relied for years on the easy availability of credit. Many businesses relied on being able to borrow money just to keep trading on a day-to-day basis. The most famous of these is Northern Rock, a medium-sized British mortgage-lender whose business model required it to constantly borrow money to repay previous debts. When it ceased to be able to borrow money, it quickly faced collapse. But the problem went far beyond mortgage-lenders and struck at something called the commercial paper market, which is the money market in which corporations borrow money to fund their day-to-day operations. Suddenly, as opposed to the credit boom, everyone found it very hard to borrow money. This was the credit crunch.
The credit crunch reached its nadir in September and October 2008, when a number of massive financial institutions either failed and went out of business or were bailed out by the government. The most famous of those in the former category was Lehman Brothers. Government bail-outs were designed to deliver a massive injection of money into the financial system to try and make institutions feel confident enough to lend money again. In the U.S. the government set up something called the Troubled Asset Relief Programme (TARP), which aimed to restore confidence by taking bad assets like sub-prime mortgages into taxpayer ownership, making the government liable for them rather than the private sector. Using this and other methods, governments sought to inject vast sums of their own money into the financial system, trying to restore credit availability to something like pre-crisis levels.
There was another key feature to the response of governments. They passed what were called fiscal stimulus packages, which basically meant that they borrowed or printed vast sums of money and then spent it inside their economies. By doing so, they hoped to compensate for the money that was no longer flowing into the economy due to the unwillingness of financial institutions to lend anyone money. Without fiscal stimuli, western economies could have ground to a complete halt, and the economic distress - in terms of rising unemployment, falling wages, and bankruptcies - could have been much more severe.
Whatever the economic arguments behind these packages, for governments they were a democratic necessity: simply allowing the economy to implode was not an option. And, in time, it was hoped that the stimuli would mitigate the worst of the credit crunch, help get the economy ticking over again, and provide a path to renewed economic growth. Whether this happens remains to be seen, as the impact of the stimuli begins to wear off, but we have to fervently hope that it does, because if our economies do not return to growth then we look unlikely to weather the third stage of the economic meltdown, which is the sovereign debt crisis.
Stage three: the sovereign debt crisis
When governments passed their bail-out and fiscal stimulus bills, it's important to understand exactly what they were doing. They weren't waving a magic wand and making the banks' bad investments vanish, or simply conjuring up money to restart western economies: they were nationalizing the problem. By borrowing huge sums of money to inject into the economy, they made the taxpayer liable for the debt. Governments have to pay their bills as well, after all. Governments borrow their money on bond markets, where they usually offer low rates of interest in return for hard currency. Rates are usually low because governments are considered safe borrowers - far from sub-prime - due to their ability to tax their populations to pay back their debts.
During the boom years before the credit crunch, many countries had become overly-reliant on the bond markets to finance their public spending; they are analogous, in many ways, to a company like Northern Rock, which needed to constantly borrow new money to pay off its old debts. Politicians across the ideological spectrum from George W. Bush to British Prime Minister Gordon Brown actually borrowed vast sums of money during the good years, taking advantage of the low borrowing costs that were available to all during the credit boom. Then, when the global economy collapsed and the credit boom ended, they faced twin problems: collapsing tax revenues, meaning they needed to borrow more money, and higher borrowing costs, which made it more expensive to borrow this money.
The stresses this has placed on some countries are unbearable. Bond market investors began to worry that some countries were taking on so much debt, with so little prospect of paying it back, that they were no longer willing to lend these countries money. This sort of thinking has a certain self-fulfilling element, because all it takes is for enough bond investors to lose confidence in the way that you have and the country won't be able to borrow and will indeed have to default on its debts. This is the process that is currently unfolding in the case of Greece and, to a lesser extent, Spain and Portugal. The solution for these governments to embark on a process of fiscal austerity: cutting their spending, and hence the amount they have to borrow, so dramatically that bond market investors regain faith in their ability to come to terms with their debts.
It might be tempting for countries to default, but if this were to happen then this wouldn't be the end of it either. If a country goes into default, all the people who lent it money will lose their investment, or a substantial part of it: in the case of Greece, for instance, this would come with a multi-hundred-billion euro pricetag for German, French, Spanish and British banks. The damage to these banks would be so severe that it would kick off yet another round of the credit crunch, and probably require another taxpayer bail-out of the banks in those countries. This bail-out would only increase the burdens faced by the governments of those countries, and increase the risk that they themselves will eventually have to default.
The path of cutting spending is not a guaranteed route to success either, because public spending helps to support the economy. There is a risk that if public spending is cut too quickly or in the wrong way, then the economy might slow down even further, leading to a collapse in tax revenues and fresh questions about the abilities of countries to repay their debts. Yet even though the immediate impact of paying back sovereign debt is to withdraw money from the economy and perhaps harm it further, in the long-run it is the only path back to sustainable growth. To simply carrying on borrowing and spending would be to act like a drunkard who deals with his hangover every morning by drinking again; eventually, he has to sober up out of choice, or he will be forced to.
This, then, is where we're up to. For America, the problem of tackling the deficit is not so immediately severe, because the U.S. benefits from a constant infusion of Chinese money which keeps the government's cost of borrowing cheap. But in Europe, the problem is severe indeed, and it has to finally be addressed by national governments. So far, we have just passed the problem around, and in many ways the real economic pain is just about to begin as fiscal stimulus is withdrawn and austerity applied. Managing the application of this austerity, ensuring it doesn't cripple the economy irreparably in the process, finding a new path to growth which isn't dependent on unsustainable credit booms, and keeping our democracies alive throughout - well, that should be enough to keep any government busy for some years yet.